Eurozone Likely to Underperform in 2014

It is increasingly likely that the Eurozone will face a weak recovery and possible stagnation in the years ahead. Economic growth in the region slowed to 0.1 percent in the third quarter compared to the second quarter, a substantial deceleration from the 0.3 percent growth rate from the first to the second quarter. Parts of the common-currency region will take off on an accelerated expansion path—think Estonia, Latvia, and Slovakia—but the GDP outlook for these tigers reaches only the 2.5-3 percent range in 2014. By contrast, the Eurozone as a whole faces a period of low prices, languishing real (inflation-adjusted) wages, suppressed consumption, and barely growing fixed investment.

Key forecasters, including the OECD, IMF, and the European Commission, all put Eurozone GDP growth at about 1 percent in 2014, and manufacturing output is set to expand close to 2 percent. Both predictions may be overly optimistic. The Eurozone’s economy is coming up against headwinds that go beyond the cyclical upturn.

The region suffers from an overreliance on external demand for generating income. In the past two years, net exports grew at an annual average rate of 2.7 percent while total GDP declined. Consumption fell slightly during that period and capital formation tumbled some 10 percentage points. In other words, domestic demand (private consumption, investment, and government spending) subtracted from growth an amount that foreign demand could not compensate for. This trend cannot be readily reversed without some form of domestic stimulus. The problem is that none is in the offing.

The private sector is income-constrained and will struggle to provide a boost. Household disposable income adjusted for inflation fell a cumulative 3.3 percent from early 2011, a substantial dent to the purchasing power of consumers. Even the household savings rate dipped—more than a percentage point of GDP since the onset of the financial crisis—upending the stylized trend of rising precautionary thrift in times of trouble.

The business sector has suffered even more. Corporate gross investment as a share of GDP fell from the 22-23 percent range just before the financial crisis to barely more than 19 percent now. This represents a substantial downward adjustment over a short period, and such underinvestment will act as a drag on future productivity and wages. Some companies stand to give ground on competitiveness relative to peers from outside the region.

Not helping matters is the fact that banks are being forced by new pan-European supervisory authorities to shore up balance sheets. Following failures of some large and small banks in the wake of previous “stress tests,” the current efforts led by the European Central Bank to improve capital adequacy are crowding out private sector lending. Since the recent peak about two years ago, bank loans to private nonfinancial institutions fell 6.4 percent cumulatively (Figure 1). The retrenchment was even steeper for loans to manufacturers—falling 7.4 percent. Many companies are generating cash and profits but they have traditionally been highly leveraged to finance everything from working capital to fixed investment. Without access to fresh funding, even at low rates, businesses will remain skeptical about expanding and hiring.

Intriguingly, this malaise strikes the Eurozone far more severely than it does the EU economies that do not share the common currency. Whereas the Eurozone’s (optimistic) GDP forecast calls for a 1 percent growth rate in 2014, the growth projections for the non-euro EU come out to twice that. This hints at a problem with the pace of the Eurozone’s recovery.

The Eurozone does not possess a centralized ability to stimulate domestic demand through fiscal channels. At national levels, tax rates may even go up in jurisdictions subject to IMF-mandated programs while in others, public spending is bound to suffer as a result of EU-mandated excessive deficit procedures. Overall, fiscal space will be austere. This situation contrasts with the fiscal ability to expand aggregate demand in countries such as Poland, the UK, and Sweden.

Monetary policy is unlikely to come to the rescue in the Eurozone. The European Central Bank has already cut its two key rates to record lows—the rate on refinancing operations to 0.25 percent and the overnight lending rate to 0.75 percent. The ECB could buy selective bank assets to prop up banks’ balance sheets but such action faces statutory hurdles, not to mention political pushback.

The upshot is that the Eurozone is stuck with an export growth strategy that depends on external and/or internal devaluation. With domestic demand growth largely absent, the road to recovery will be slow. The consensus GDP projections probably overstate both the length and strength of recovery.